€100 billion in fresh support to the Spanish government failed to calm markets; private investors asked for even higher risk premiums on Spanish bonds. Conventional wisdom is that this reaction reflects the way any new official debt – which gets paid off first in case of distress – harms private debt holders. This column challenges this subordination logic and argues that Spain’s latest bank bailout announcement actually increased the value of privately held Spanish sovereign debt..

The usually purely technical issue of subordination has become a discussion for Eurozone leaders as well as Vox columnists (Gros 2012). The standard view is that fresh public lending can reduce the value of the existing debt held by private investors since the public lenders come first in the queue if the country has to reschedule (e.g. the IMF loans to Greece were untouched by the last restructuring).

We challenged this conventional view (Ghezzi 2012). Although it imposes seniority, fresh official lending is frequently offered at subsidised, below-market rates, which can free up resources for future debt service to private creditors. As such, official financing can increase the overall size of the pie available to service debt holders, even as seniority reduces the percentage of the pie available to subordinated bondholders.

Application to the Spanish case

In this column, we apply the framework to address the impact of the recent Spanish bank bailout announcement. Spanish Economy Minister Luis de Guindos announced on Saturday 9 June that he had requested financial assistance from the Eurozone countries to complete the restructuring of the banking system. The financial assistance would be provided by the European Financial Stability Facility (EFSF) and/or the European Stability Mechanism (ESM) for recapitalisation of financial institutions. The loan amount is estimated to total up to €100 billion. Full details of the programme are not out yet. It is expected to have a yield between 3% and 4% and to have a very long tenorsmaturity. It appears as if the support entity will be the ESM. The ESM still needs to be approved in a number of countries but should be ready by 9 July. Its debt is senior to existing private debt so subordination issues will arise.

Our framework allows us to assess the impact of the programme on potential recovery values for bondholders. In particular, we can then use the formulas explain in the previous post to estimate the impact on recovery values. We will assume that the EU debt is senior (hence it is ESM debt).

The Spanish public sector debt, including a worst-case scenario of €100 billion (10% of GDP) of bank recapitalisation and this year’s fiscal deficit, is likely to be 85% of GDP at the end of 2012 (from less than 70% at the end of 2011).1,2 We need to determine whether the senior lending reduces recovery values vs. the counterfactual of Spain issuing bonds (for 10% of GDP) that could be used by the banks as repo securities at the ECB. Finally, we assume that the maximum feasible Spanish primary balance (PBMAx) is 2.25%.

We don’t know the financing conditions of the potential ESM loan. We will assume however, that it is very long term and at a rate of 3.5%.3

We are expecting nominal GDP growth of -0.8% in 2012, moving towards 3.25% in 2015 (2.09% in 2011).4 We can assume, pessimistically, an average rate of 2% in the long term. Using these numbers the formulas, we find that the EU loan would increase recovery values as long as the necessary primary surplus is less than the maximum feasible Spanish primary balance. Doing the maths we see that a reason Spanish bailout would raise recovery values since the required primary balance, 1.25%, is less than what we think Spain can handle, namely (0.035 – 0.02)/(1.02)0.85 = 1.25% < 2.25%.

The concessional interest rate could be as high as 4.7% and still increase recovery values given our other assumptions. Likewise, assuming a concessional rate of 3.5%, nominal growth could be as low as 0.8% and the low rates would still increase recovery values. Interestingly enough, recent reports (see here) suggest authorities are moving into the direction of lower rates and higher tenors to maximize the benefits to the country (and implicitly increase recovery values to investors).

Two additional points are worth highlighting.

First, the market reacted negatively to the recapitalisation announcement.

Why did investors react negatively to the Spanish bank recapitalisation announcement if the terms of the loan actually satisfy your conditions for increasing recovery values? In our view, the sell-off does not have much to do with the subordination, or at least cannot be justified by it. Instead, it is related to the potentially significant downside of the banking losses to which the Spanish sovereign is exposed. With the increased expected costs of bank recapitalisation, most observers have ratcheted up their own estimates of the worst-case scenario. This is particularly relevant for Spain, as rising problem loans are the result of a boom-bust in the real estate sector and the bottom is not yet in sight: housing prices are still falling and economic activity contracting.

Put differently, even after the reports by the private auditors on the size of the loan needed to recapitalise financial institutions, we expect markets to remain edgy because even if the expected costs are in line with consensus, the potential downside risk will remain a market focus. It is difficult to believe that auditing can take the tail of the distribution away. This would be different if the EFSF/ESM would take (part of the) credit risk from potential future bank losses, but this is not currently under discussion.

We also think that part of the nervousness of investors is related to the unappealing risk reward of holding the bonds. Take the equation of fair spreads from our previous column:

Fair spread = P * (1 – R) + risk premium (1)

where P is the yearly default probability and R is the recovery value in the event of a default. Spreads of, say, 500bp (assuming a recovery value of 50% and risk premium of 1/3 of the default probability) are consistent with an implicit default probability of only 7.5%. In other words, risks are very asymmetric for bondholders (at least for foreign ones) and this explains why bonds are not attractive even at these yields. This is a process that will almost certainly dominate the recovery value discussion. But again, senior loans don’t exacerbate the process. If anything, they soften the blow.

Second, it is relevant to point out the announcement of the official loan from the ESM or EFSF did not make the losses any bigger.

Once the losses are acknowledged, the realistic choices are between Spain issuing bank recapitalisation bonds or a bank recapitalization bond issued by the EFSF/ESM to the sovereign that subordinates the rest of government creditors (with the recapitalisation bonds, Spanish banks can tap Eurosystem liquidity). According to our calculations, existing bondholders are better off, all else being equal, with senior EFSF/ESM financial support at the concessional rate that is being suggested (3-4%) than with recapitalisation bonds that would otherwise have to be issued.

For sure, investors would have been even better off if the European Financial Stability Facility (EFSF) had been the lending vehicle given that it is not senior or if the combined EFSF/ESM had injected capital directly into the banks, thereby taking the credit risk instead of the Spanish sovereign.

1 Our baseline is that ESM resources for bank recapitalisation are €60 billion. We use €100 billion in these calculations as the objective is to estimate potential recovery values, which is conditional to a worst case of default.
2 Hence “D” equals 85% and D1 = 10%.
3 Conditions (8) and (8a) assume official debt is very long tenor in line with recent developments. Shorter-term debt would imply that the interest rate ρ utilised in the formulae would need to be a weighted average of the concessional rate and the market rate. Hence the shorter the tenor the lower the concessional rate needed to increase recovery values.
4 Before proceeding with the computations, we note that we assumed a nominal growth rate equal to zero in the formulas (see the previous post for details), but here we allow for growth so the condition to increase recovery values is: (ρ – g )/(1+g)D < PBMAX.